The devil is in the detail

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London-based economist Andrew Hunt tells a story that shows regulation is hurting financial services all around the world - not just in New Zealand.

Tuesday, August 5th 2014, 10:30AM 1 Comment

by Andrew Hunt

A few months ago, we found ourselves visiting with a senior executive at one of the US’s larger banks at their New York headquarters, in part to talk about the world and to catch up on the “industry gossip”. Outwardly, the finance industry – and the financial markets – seem to be doing well at present but when we asked him how the business was going and, more importantly, whether he saw anything that worried him.

His response was “the main thing that worries me is that we don’t want to even be a bank anymore”.

His angst was simply that, following the GFC and the advent of more regulation and ultra-low interest rates, the likely return to investors (and employees?) for being involved within the official banking sector was now minimal; anything that they were supposed to do – such as lend to real people – no longer generated a decent expected return, while anything “interesting” was pretty much forbidden by the regulators who seemed to be knocking on his door at least once a week. 

In this respect, it does seem that the pendulum from unfettered banking in the mid-2000s may have swung rather too far back the other way towards a degree of over-regulation in some areas, as it often does following a major banking crisis. Indeed, we have long wondered whether the well-recognised 60-70-year-long cycle in the global economy is actually created by differing generations of banking regulator: the first generation are ultra-conservative, with the result that the system may be credit constrained; the second generation then eases up, but the third generation tends to be quite laissez-faire with the result that credit booms and busts tend to emerge…

We also asked our contact if he saw anything in the wider financial system that particularly scared him and his response was “yes – over there” and he pointed to the building opposite, which apparently now houses a new and completely unregulated “repo credit provider”, which we gather even falls outside the authorities’ data collection programme, let alone their supervision.

Although seemingly esoteric and certainly very much hidden from view, the “securities repurchase” credit markets, in which would-be borrowers can borrow for short durations by posting suitable bonds as collateral, have grown since the GFC to be the largest short-term credit markets within the system, handling many trillions of dollars of credit each day. These repo markets are used primarily by financial institutions but their operational reliance on “eligible collateral” (which was originally assumed to be their strength) can create problems when there is either a shortage of collateral or someone somewhere within the complex chain of financial inter-relationships fails to either pay off their loans or even to deliver the appropriate collateral at the appointed time. 

Just a few weeks ago, the volume of failed trades within these repo markets increased by over 300% following what seems to have been a change in repo market behaviour by the New York Federal Reserve that left the system “short” of collateral. We doubt that the Fed intended to create such an outcome and therefore it must probably be put down as an expensive accident that might have had far-reaching consequences had the building crisis not been eased by the hasty re-injection of more collateral into the system over the following few days.

We suspect that the underlying problems within the repo markets is in fact less to do with their own intrinsic structure (which in theory should be quite robust), the ultra-low level of interest rates and the low level of financial market volatility that has been caused by the central bank’s over-long operation of their quantitative easing programmes (QEPs) and asset purchases. The low rates and low volatility environment of recent years has encouraged and indeed obliged those hoping to make “excess returns” to run huge leveraged positions. In fact, by creating such a low rate/low volatility environment, the authorities have unwittingly created conditions that are ripe for a return to the type of Greenspan-put-era moral hazard problems that we witnessed in the late 1990s and 2000s. Although the conventional banks may now be prohibited from participating in these games by the regulators, as our contact noted there are seemingly plenty of relatively unregulated “new” players within the system who do wish to participate. 

With borrowing costs so low and apparently so certain, agents are being encouraged to run highly leveraged large sized positions. Investors are using more and more “risk” in an effort to offset the central banks’ attempted suppression of risk and volatility but the result of this has – somewhat ironically – become a more fragile system, as last month’s surge in failed repo trades revealed all too clearly.

This is not the only moral hazard problem that the Federal Reserve’s QEP has created. According to the FRB’s own data, the Federal Reserve has acquired around US$900 billion of high grade bonds over the last year, while the commercial banks have acquired a further US$130 billion. As a consequence, the banking system has “taken out of circulation” over a trillion dollars of “good quality bonds” from the markets’ available supply at a time in which Treasury bond issuance by the government has been well below this amount, with the result that there has been an effective shortage of bonds for investors such as pension funds and other savers. In effect, the Fed’s QEP has created not just low bond yields but a physical shortage of bonds (a recurring theme in this piece) that have together forced savers and other investors into other bond markets, such as the emerging markets and the US’s own corporate bond markets.
In a sense, there have been hundreds of billions of dollars looking for a home within the bond markets and the suppliers of bonds have seen this as something of an “opportunity”.

Hence, we have witnessed a surge in EM bond issuance – with China leading the way – and a massive increase in the issuance of corporate bonds in the US and elsewhere.

At present, if the quasi-official SIFMA data is to be believed, US companies are issuing over US$1,500 billion of corporate bonds per annum in gross terms (equal to about US$700 billion in net terms) and the highest ever proportion (roughly a third) of these newly issued instruments are now officially classed as high yield rather than investment grade. Never ones to shy away from an opportunity it seems, the US corporate sector has launched itself into yet another borrowing binge that has already succeeded in lifting its level of debt to new records relative to US GDP – levels that are now well above those witnessed immediately prior to the GFC.

Interestingly, we find that according to the FRB’s data, companies are generating around US$1.8 trillion in cashflow (that is, profits after tax and with depreciation) from their day-to-day businesses, but at the same time only investing US$1,300 billion in real productive assets, thereby implying that they are notionally in receipt of almost US$1.5 trillion of “cash” from their operations and borrowings each year.  This cash is then being put to work funding equity buybacks, capital divestments, M&A activity, share option payments and the acquisition of other financial assets. These types of activities tend to be viewed favourably by today’s generation of equity portfolio managers and so they are likely to be both directly and indirectly supportive of asset markets. 

We would argue that this massive implied corporate “bid” for equities makes it most unlikely that share prices – or share option prices – can fall meaningfully while this process is intact. Those interested in the “agency problem” and other wider issues associated with the current forms of corporate governance, though, are beginning to fret since not only are companies increasing their levels of debt, they seem to be actively avoiding capital expenditure in the real economy, something that bodes well not just for the outlook for their core businesses but also for society as a whole. 

We have already witnessed a sharp slowdown in productivity and trend GDP growth within the US over the last decade and we would apportion at least some of the blame for this on the relative lack of business investment that has occurred since companies became overly distracted by these financial engineering games.

Crucially, and once again according to SIFMA, we find the average duration of the hundreds of billions of dollars of bonds that are being issued by US corporations at present has increased to over 13 years since the GFC. The average tenure of a non-executive director of a company, though, is below 10 years and the likely tenure of an executive director is lower than this, while the average length of an employee share option scheme is below five years. Consequently, we can suggest that many of the executives who are deciding to increase the leverage in their companies are likely to gain from their actions on a personal level within the next five years while at the same time they are unlikely to be “around” when the debt that they are issuing matures.

This is not to say that they are doing anything legally “wrong” – there is no malfeasance involved although one can argue whether their actions are benefiting society as a whole –but this is the “moral hazard” world that the FRB is creating.

Unsurprisingly, we also now know that there are those within the US central bank who would dearly like to end this game and, judging by her apparent enthusiasm for the tapering of the FRB’s bond purchases, we suspect that Ms Yellen may even be amongst them. QE may have supported the financial system and the markets but, as Yellen herself is quick to point out, the real economy is neither growing fast enough nor generating the right sort of high-income paying jobs that the authorities would like to see. Hence, we may already be overdue a change of policy tack by the Fed.

After years of “pushing” QE onto the world we doubt that the FRB would like to mount any form of public U-turn on the subject, not least of all because it would presumably threaten the markets and the “wealth effect” that the central bank has been pursuing for all these years. Therefore, it seems to us that the FRB is likely to start or continue experimenting on some form of “soft exit” from QE – we don’t expect any rate rises but we do expect them to continue tapering and to conduct other “experiments” in liquidity management but, as the New York Fed unwittingly discovered when it altered its own behaviour in the repo markets only a few weeks ago, any unexpected action by the central bank can have unforeseen consequences in today’s once-again heavily leveraged world. 

In short, we do not expect the FRB to put on its “big boots” and deliberately kick the markets but even tiptoeing around may create volatility given just how extended the latest credit boom in the US has been. While not outright bearish at present, we are beginning to think that now may be a time for investors to move a little closer to their benchmarks in case the FRB trips up the markets inadvertently.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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